The Pros And Cons Of Automated Trading Systems
By Jean Folger
September 11, 2014
Traders and investors can turn precise entry, exit and money management rules into automated trading systems that allow computers to execute and monitor the trades. One of the biggest attractions of strategy automation is that it can take some of the emotion out of trading since trades are automatically placed once certain criteria are met. This article will introduce readers to and explain some of the advantages and disadvantages, as well as the realities, of automated trading systems. (For related reading, see The Power Of Program Trades.)
What Is An Automated Trading System?
Automated trading systems, also referred to as mechanical trading systems, algorithmic trading, automated trading or system trading, allow traders to establish specific rules for both trade entries and exits that, once programmed, can be automatically executed via a computer. The trade entry and exit rules can be based on simple conditions such as a moving average crossover, or can be complicated strategies that require a comprehensive understanding of the programming language specific to the user's trading platform, or the expertise of a qualified programmer. Automated trading systems typically require the use of software that is linked to a direct access broker, and any specific rules must be written in that platform's proprietary language. The TradeStation platform, for example, uses the EasyLanguage programming language; the NinjaTrader platform, on the other hand, utilizes the NinjaScript programming language.
Some trading platforms have strategy building "wizards" that allow users to make selections from a list of commonly available technical indicators to build a set of rules that can then be automatically traded. The user could establish, for example, that a long trade will be entered once the 50-day moving average crosses above the 200-day moving average on a five-minute chart of a particular trading instrument. Users can also input the type of order (market or limit, for instance) and when the trade will be triggered (for example, at the close of the bar or open of the next bar), or use the platform's default inputs. Many traders, however, choose to program their own custom indicators and strategies or work closely with a programmer to develop the system. While this typically requires more effort than using the platform's wizard, it allows a much greater degree of flexibility and the results can be more rewarding. (Unfortunately, there is no perfect investment strategy that will guarantee success. For more, see Using Technical Indicators To Develop Trading Strategies.)
Once the rules have been established, the computer can monitor the markets to find buy or sell opportunities based on the trading strategy specifications. Depending on the specific rules, as soon as a trade is entered, any orders for protective stop losses, trailing stops and profit targets will automatically be generated. In fast moving markets, this instantaneous order entry can mean the difference between a small loss and a catastrophic loss in the event the trade moves against the trader.
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Advantages of Automated Trading Systems
There is a long list of advantages to having a computer monitor the markets for trading opportunities and execute the trades, including:
- Minimize Emotions. Automated trading systems minimize emotions throughout the trading process. By keeping emotions in check, traders typically have an easier time sticking to the plan. Since trade orders are executed automatically once the trade rules have been met, traders will not be able to hesitate or question the trade. In addition to helping traders who are afraid to "pull the trigger", automated trading can curb those who are apt to overtrade buying and selling at every perceived opportunity.
- Ability to Backtest. Backtesting applies trading rules to historical market data to determine the viability of the idea. When designing a system for automated trading, all rules need to be absolute, with no room for interpretation (the computer cannot make guesses it has to be told exactly what to do). Traders can take these precise sets of rules and test them on historical data before risking money in live trading. Careful backtesting allows traders to evaluate and fine-tune a trading idea, and to determine the system's expectancy the average amount that a trader can expect to win (or lose) per unit of risk. (We offer some tips on this process that can help refind your current trading strategies. For more, see Backtesting: Interpreting the Past.)
- Preserve Discipline. Because the trade rules are established and trade execution is performed automatically, discipline is preserved even in volatile markets. Discipline is often lost due to emotional factors such as fear of taking a loss, or the desire to eke out a little more profit from a trade. Automated trading helps ensure that discipline is maintained because the trading plan will be followed exactly. In addition, pilot-error is minimized, and an order to buy 100 shares will not be incorrectly entered as an order to sell 1,000 shares.
- Achieve Consistency. One of the biggest challenges in trading is to plan the trade and trade the plan. Even if a trading plan has the potential to be profitable, traders who ignore the rules are altering any expectancy the system would have had. There is no such thing as a trading plan that wins 100% of the time losses are a part of the game. But losses can be psychologically traumatizing, so a trader who has two or three losing trades in a row might decide to skip the next trade. If this next trade would have been a winner, the trader has already destroyed any expectancy the system had. Automated trading systems allow traders to achieve consistency by trading the plan. (It's impossible to avoid disaster without trading rules. For more, see 10 Steps to Building a Winning Trading Plan.)
- Improved Order Entry Speed. Since computers respond immediately to changing market conditions, automated systems are able to generate orders as soon as trade criteria are met. Getting in or out of a trade a few seconds earlier can make a big difference in the trade's outcome. As soon as a position is entered, all other orders are automatically generated, including protective stop losses and profit targets. Markets can move quickly, and it is demoralizing to have a trade reach the profit target or blow past a stop loss level before the orders can even be entered. An automated trading system prevents this from happening.
- Diversify Trading. Automated trading systems permit the user to trade multiple accounts or various strategies at one time. This has the potential to spread risk over various instruments while creating a hedge against losing positions. What would be incredibly challenging for a human to accomplish is efficiently executed by a computer in a matter of milliseconds. The computer is able to scan for trading opportunities across a range of markets, generate orders and monitor trades.
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